Photo Credit: Alcino || What is the sound of negative one hand clapping?

Photo Credit: Alcino || What is the sound of negative one hand clapping?

As with many of my articles, this one starts with a personal story from my insurance business career (skip down four paragraphs to the end of the story if you want):

25 years ago, when it was still uncommon, I wanted to go to an executive course at the Wharton School for actuaries that wanted to better understand investment math and markets.  I went to my boss at AIG (a notably tight-fisted firm on expenses) and asked if the company would pay for me to go… it was an exclusive course, and very expensive compared to any other conference that I would ever go to again in my life.  I tried not to get my hopes up.

Lo, and behold!  AIG went for it!

A month later, I was with a bunch of bright actuaries at the Wharton School.  The first thing I noticed was aside from the compound interest math, and maybe some bond knowledge, the actuaries were rather light on investment knowledge, and I would bet that all of them had passed the Society of Actuaries investment course.  The second thing I noticed were some of the odd investments described in the syllabus: it was probably my first taste of derivative instruments.  At the ripe old age of 29, I was learning a lot, and possibly more than the rest of my classmates, because I had spent a lot of time studying investments already, both on an academic and practical basis.

I had already studied the pricing of stock options in school, so I was familiar with Black-Scholes.  (Trivia note: an actuary developed the same formula for valuing optionally terminable reinsurance treaties six years ahead of Black, Scholes and Merton.  That doesn’t even take into account Bachelier, who derived it 73 years earlier, but no one knew about it, because it was written in French.)  At this point, the professor left, and a grad student came in to teach us about the pricing of bond options.  At the end of his lesson, it was time for the class to have a break.  I went down to make a comment, and it went like this:

Me: You said that we have to adjust for the fact that interest rates can’t go negative.

Grad student: Of course.

Me: But interest rates could go negative.

GS: That’s ridiculous!  Why would you ever lend money and accept back less than you gave them, and lose the time value of money?!

Me: Almost of the time, you wouldn’t.  But imagine a scenario where the demand for loanable funds leaves interest rates near zero, but the times are insecure and violent, leaving you uncertain that if you stored your cash privately, you would run too large of a risk of having it stolen.  You need your cash in the future for a given project.  In this case, you would pay the bank to store your money.

GS: That’s an absurd scenario!  That could never happen!

Me: It’s unlikely, I admit, but I wouldn’t say that you can never have negative interest rates.

GS: I will say it again: You can NEVER have negative interest rates.

Me: Thanks, I guess.

Well, so much for the distant past.  Here is why I am writing this: yesterday, a friend of mine wrote me the following note:

Good evening.  I trust you had a blessed Lord’s Day in the new building. 

Talking bonds today with my Econ class.  Here’s our question. Other than playing a currency angle why would anyone buy European debt with a negative yield?  The Swiss and at least one other county sold 10 year notes with a negative yield.  Can you explain that?  No interest and less principle [sic] at the end.

Now, I didn’t quite get it perfectly right with the grad student at Wharton, but most of it comes down to:

  • Low demand for loanable funds, with low measured inflation, and
  • Security and illiquidity of the funds invested

The first one everyone gets — inflation is low, and few want to borrow, so interest rates are very low.  But that doesn’t explain how it can go negative.

Things are different for middle class individuals and large financial institutions.  Someone in the middle class facing negative interest rates from a checking or savings account could say: “Forget it.  I’m taking most of my money out of the bank, and storing it at home.”  Leaving aside the inconvenience of currency transaction reports if the amount is over $10,000, and worries over theft, he could take his money home and store it.  Note that he does have to run a risk of theft, though, so bringing the money home is not costless.

The bank has the same problem, but far larger.  If you don’t invest the money, where would you store it?  Could you even get enough currency delivered to do it?  if you had a vault large enough to store it, could you trust the guards?  Why make yourself a target?  If you don’t have a vault large enough to store it, you’re in the same set of problems that exist for those that warehouse precious metals, but with a far more liquid commodity.

Thus in a weak economic environment like this, with low inflation, banks and other financial institutions that want certainty of payment in the future are willing to pay interest to get their money back later.

Part of the problem here is that the fiat currencies of the world exist only to be units of account, and not stores of value.  Thus in this unusual environment, they behave like any other commodity, where the prices for futures are often lower than the current spot price, which is known as contango.  The rates can’t get too negative, though, or some institutions will bite the bullet and store as much cash as they can, just as other commodities get stored.

To use another analogy, a while ago, some market observers couldn’t get why anyone would accept a negative yield on Treasury Inflation Protected Securities [TIPS].  They did so because they had few other choices for transferring money to the future while still having inflation protection.  Some people argued that they were locking in a loss.  My comment at the time was, “They’re trying to avoid a larger loss.”

Thus the difficulty of managing cash outside of the bond/loan markets in a depressed economy leads to negative interest rates.  The financial institutions may lose money in the process, but they are losing less money than if they tried to store and protect the money, if that could even be done.

Data Credit: CIA FactbookI write about this every now and then, because human fertility is falling faster then most demographers expect. Using the CIA Factbook for data, the present total fertility rate for the world is 2.425 births per woman that survives childbearing. That is down from 2.45 in 2013, 2.50 in 2011, and 2.90 in 2006. At this rate, the world will be at replacement rate (2.1), somewhere between 2025 and 2030. That’s a lot earlier than most expect, and it makes me suggest that global population will top out at 8.5 Billion in 2050, lower and earlier than most expect.

Have a look at the Total Fertility Rate by group in the graph above. The largest nations for each cell are listed below the graph. Note Asian nations to the left, and African nations to the right.

Africa is so small, that the high birth rates have little global impact. Also, AIDS consumes their population, as do wars, malnutrition, etc.

The Arab world is also slowing in population growth. When Saudi Arabia is near replacement rate at 2.17, you can tell that the women are gaining the upper hand there, which is notable given the polygamy is permitted.

In the Developed world, who leads in fertility? Israel at 2.62. Next is France at 2.08 (Arabs), New Zealand at 2.05, and the US at 2.01, slightly below replacement. We still grow from immigration, as does France.

Most of the above is a quick update of my prior piece, which has some additional crunchy insights.  This evening, I would like to highlight two articles that I saw recently — one on troubles with municipal pensions, and one on how some areas of China are dying.  They are at root the same story, but with different levels of potency.

Let me start with the amusing question where Arnold Schwarzenegger asks Buffett via CNBC what can be done to solve the municipal defined benefit pension problem, which Becky Quick then asks Buffett.  For the next 80 seconds, Buffett says it is a messy problem created by politicians that voted for high municipal pensions, because future generations would pay the bill, and not current taxpayers.  The politicians that voted for them are long gone.  Buffett offers no solutions, and I don’t blame him because all of the solutions are ugly.  Here they are:

  • If state law allows, terminate the current plans and replace them with Defined Contribution plans, or reduce the rates of future accrual.  If those can’t be done, create a new Defined Contribution plan for all new employees, who will no longer participate in the Defined Benefit plans.  Even the last of these will be fiercely resisted by municipal unions.
  • Cancel the cost of living adjustment, if you can do so legally.
  • Raise taxes — I’m sure younger people will enjoy paying for past services of municipal employees.
  • Impose excise (or something like that) taxes on municipal pension payments, and rebate the money back to the plans.
  • Declare or threaten bankruptcy if you can legally do it, and try to extract concessions from the representatives of pensioners.
  • Amend the state constitution to change the status of pension benefits, including adding an exception adding legality to adjust benefits after the fact. (ex post facto)

Don’t get me wrong.  I don’t think the radical solutions could/would ever be done, and the National government would probably slap down any state that actually tried something draconian.  Remember, states are practically administrative units of the national government.  States’ rights is a nice phrase, but often very empty of power.

Here are some non-solutions:

  • Float pension bonds — just a form of leverage, substituting a fixed liability for a contingent liability, and assuming that you can earn more than the rate paid on the pension bonds.
  • Invest more aggressively.  Sorry, taking more risk won’t do it.  Returns are only weakly related to risk, and often taking high risks leads to lower returns.  The returns you are likely to get depend mostly on the entry prices you pay for the underlying cash flow streams in question.
  • Invest in alternative assets.  Sorry, you are late to the game.  Alternatives offer little more than conventional assets at present, and they carry high fees and illiquidity.
  • Adjust the discount rate, or salary increase rate assumption.  That may make the current problem look smaller, but it doesn’t change the underlying benefits to be paid, or the returns the assets will earn.  If anything, the assumptions are too aggressive now, and plan assets are unlikely to return much more than 4%/year over the next 10 years.

Buffett gave one cause for the problem, but there is one more — if the US population were growing rapidly, there would be a larger base of taxpayers to spread the taxes over.  Diminished fertility feeds into the problems in the states, as well as other social insurance schemes, like Social Security and Medicare.  You could loosen up immigration to the US, particularly for younger, wealthy, and or/skilled people, but that has its controversial aspects as well.

Here’s another way of phrasing it — it’s difficult to create workers out of thin air.  Governments would like nothing better than to have more working age people magically appear.  It would solve the problem.  Alas, those decisions were largely made 20-40 years ago also.  There is even competition now for the best immigrants.

That brings me to the article on China. Rudong, a city in China where the one-child policy began, is now an elderly place with few younger people to take care of the elderly.  Kind of sad, even if the problem was partially self-inflicted, and partially inflicted by conceited elites who thought they were doing a good thing.

A few quotations from the article:

“China will see more places like Rudong very soon,” said Wang Feng, a professor of sociology at the University of California at Irvine. “It’s a microcosm of the rapid demographic and economic transformation China has been experiencing the last decades. There will be more ghost villages and deserted or sleepy towns.”

also:

“China is quickly turning gray on an unprecedented scale in human history, and the Chinese government, even the whole Chinese society, is not prepared for it,” Yi said. “In many places, including my hometown in western Hunan, it’s hard to find a young man in his 20s or 30s.”

and also:

What’s different in China is that the one-child policy accelerated the process, removing hundreds of millions of potential babies from the demographic pool. China’s old-age dependency ratio — a measure of those age 65 or over per 100 of working age — is set to triple by 2050, to 39.

The one-child policy created possibly the sharpest demographic shift in the world.  It is largely irreversible; once women as a culture stop having children, they don’t start having more when benefits are offered or penalties are lowered.  It would take a big change in mindset in order to get that to shift, like a religious change, or the aftermath of a big war.

The Christians are growing in China, and many of them would have larger families, but even if Christianity gets a lot bigger, and the Party tolerates it, that won’t come fast enough to deal with the problems of the next 30 years, but it could help with the problems after that.

In closing, there is enough pity to go around.  Pity for the elderly that will not get taken care of to the degree that they would like.  Pity for those younger who cannot afford the time or monetary costs of taking care of the elderly.

I think the only solution to any of this would be shared sacrifice, where everyone gets hurt somewhat.  My question would be what places in the world have the requisite maturity to achieve such a solution.  Optimistically, the answer would be many, but only after a lot of sturm und drang.

Photo Credit: Tulane Public Relations || James Carville wants to be "reincarnated" as the bond market, to scare everyone -- boo!

Photo Credit: Tulane Public Relations || James Carville wants to be “reincarnated” as the bond market, to scare everyone — boo!

I was reading this article at Reuters, and musing at how ludicrous it is for the Fed to think that it can control the reaction of the bond market to tightening Fed policy, should it ever happen.  The Fed has never been able to control the bond market, except on the short end, and only with the highest quality paper.

The long end is controlled by the economy as a whole, and its rate of growth, while lower quality bonds and loans also respond more to where the credit cycle is.  The Fed has never been able to tame the credit cycle — the boom and the bust.  If anything, they make the booms and busts worse.

Now they think that their new policy tools will enable them to control the bond market.  The new tools are nothing astounding, and still mostly affect short and high quality debts.

One thing is certain — when the Fed starts tightening, some levered parties will blow up.  Even the mention of the taper caused shock waves in the emerging bond markets.  And when something big blows up, the Fed will stop tightening.  It always happens, and they always do.

So please give up the idea that the Fed can do what it wants.  It looks like it can in the short-run, but in the long run markets do what they want, and the Fed has to respond, rather than lead.

Crawling to the first tightening move

Crawling to the first tightening move

There was a lot of hoopla yesterday over the FOMC removing the word “patient” from its statement.  But when you read the sentence that replaced the sentence containing the word patient, you shouldn’t think that much has changed:

Consistent with its previous statement, the Committee judges that an increase in the target range for the federal funds rate remains unlikely at the April FOMC meeting. The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term. This change in the forward guidance does not indicate that the Committee has decided on the timing of the initial increase in the target range.

There are two contingencies here, which are both subject to considerable latitude in interpretation:

  • Seeing further improvement in the labor market
  • Being reasonably confident that inflation will move back to its 2 percent objective over the medium term

I have long argued that the FOMC doesn’t have a strong theory for what they are doing, and have designed their language in speaking to the markets to maximize their flexibility.  It has not been the obfuscation of the overly confident Greenspan era, but the endless blather that comes from trying to be “transparent” and drown the market in communications, because they never quite understand us properly.

Now, for the first time in a while, the FOMC statement shrank, and for that, I thank the FOMC.  It should shrink further, and it would be better if the FOMC said nothing, and went back to pre-Greenspan practices, and let the actions of the Open Markets Desk at the New York Fed do the talking.  Deeds, not words.

Now, data isn’t the same as deeds, and they aren’t always as clear as words, but the FOMC gave us a release of the forecasts of its members yesterday.  The graphs in this piece reflect the central tendency of their estimates, giving proper weight to the dominant views, as well as less weight to the views from the outliers.

Start with the graph at the top of this article.  The average of all of the views suggests tightening in September.  Now, with 15 favoring a move in 2015, a move will likely happen this year.  If you look back through their data releases, a preponderance of opinion has pointed to 2015 since September of 2012, with never fewer than 12 members pointing to a move in 2015 since then.

But what of the shift in opinions regarding the level of the Fed Funds rate over time?  What happened to that with the removal of the “patient” language?

My but they got more dovish...

My but they got more dovish…

Look at the reduction in the expected end of year Fed Funds rate — down 0.35% in 2015 (to 0.77%), 0.51% in 2016, 0.32% in 2017, and 0.12% in the long run.  That last number is significant, because of the change in composition of those giving opinions, and it indicates a more generally dovish group.

But the downward moves in values indicate fewer tightening moves for 2015 — at present the estimate would be 2-3 quarter-percent moves. (And five more eaches in 2016 and 2017, for those who dream that savers might get some compensation, and that the government’s budget works at higher levels of interest rates)

A big reason for the shift is the move in views on PCE inflation:

Still behind the deflationary curve...

Still behind the deflationary curve…

That’s a 0.59% move down in PCE inflation estimates for 2015. Odds are, it will be lower than that. The FOMC as forecasters always chase trends, and rarely get ahead of them. They also believe in the power of monetary policy to produce inflation, and more perversely, growth. As it is, their actions have produced little of either.

It does explain why their estimates for 2016 and beyond are so high. Would any of the members dare to break from the lockstep, and concede that monetary policy does not have significant power to affect the economy for good?

Here is the real GDP graph:

Down, down, down...

Down, down, down…

Note the continued move down in estimates for all future periods. Interesting to see the pessimistic shift.

Finally, the unemployment rate graph:

Discouraged workers of the world unite, you have nothing to lose but...

Discouraged workers of the world unite, you have nothing to lose but…

There are many jobs to be had, if people will search for them, and if they think the wages are worth taking, versus alternatives of leisure, working in unreported labor markets, etc…

Conclusion

Looking at the data, the FOMC certainly isn’t hawkish at present. That is consistent with the change in language in the statement, which left timing for any future hikes in the Fed Funds rate vague, and subject to interpretation. This explains the fall in the US Dollar, and the rise in the prices of stocks, long bonds, and commodities. The markets viewed it all as continued monetary lenience, and given the composition of voting members on the FOMC, that should come as no surprise at all.

Until something breaks, expect the FOMC to continue to err on the side of monetary lenience… it’s the only thing they know.

Photo Credit: Day Donaldson

Photo Credit: Day Donaldson

January 2015March 2015Comments
Information received since the Federal Open Market Committee met in December suggests that economic activity has been expanding at a solid pace.Information received since the Federal Open Market Committee met in January suggests that economic growth has moderated somewhat.Shades GDP down.
Labor market conditions have improved further, with strong job gains and a lower unemployment rate.  On balance, a range of labor market indicators suggests that underutilization of labor resources continues to diminish.Labor market conditions have improved further, with strong job gains and a lower unemployment rate. A range of labor market indicators suggests that underutilization of labor resources continues to diminish.No change.
Household spending is rising moderately; recent declines in energy prices have boosted household purchasing power.  Business fixed investment is advancing, while the recovery in the housing sector remains slow.Household spending is rising moderately; declines in energy prices have boosted household purchasing power. Business fixed investment is advancing, while the recovery in the housing sector remains slow and export growth has weakened.Shades down their view of exports.

 

Inflation has declined further below the Committee’s longer-run objective, largely reflecting declines in energy prices.  Market-based measures of inflation compensation have declined substantially in recent months; survey-based measures of longer-term inflation expectations have remained stable.Inflation has declined further below the Committee’s longer-run objective, largely reflecting declines in energy prices. Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations have remained stable.Notes flattening of implied future inflation rates.  TIPS are showing lower inflation expectations since the last meeting. 5y forward 5y inflation implied from TIPS is near 1.94%, down 0.09% from January.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.No change. Any time they mention the “statutory mandate,” it is to excuse bad policy.
The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators continuing to move toward levels the Committee judges consistent with its dual mandate.The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators continuing to move toward levels the Committee judges consistent with its dual mandate.No change. They are no longer certain that inflation will rise to the levels that they want.
The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced.  Inflation is anticipated to decline further in the near term, but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of lower energy prices and other factors dissipate.  The Committee continues to monitor inflation developments closely.The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced. Inflation is anticipated to remain near its recent low level in the near term, but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of energy price declines and other factors dissipate. The Committee continues to monitor inflation developments closely.CPI is at -0.2% now, yoy.  No change in language.
To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate.  In determining how long to maintain this target range, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation.  This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.No change.
Based on its current assessment, the Committee judges that it can be patient in beginning to normalize the stance of monetary policy.  However, if incoming information indicates faster progress toward the Committee’s employment and inflation objectives than the Committee now expects, then increases in the target range for the federal funds rate are likely to occur sooner than currently anticipated.  Conversely, if progress proves slower than expected, then increases in the target range are likely to occur later than currently anticipated.Consistent with its previous statement, the Committee judges that an increase in the target range for the federal funds rate remains unlikely at the April FOMC meeting. The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term. This change in the forward guidance does not indicate that the Committee has decided on the timing of the initial increase in the target range.Removes the concept of patience.  Looks for further labor market improvement, and an increase in inflation expectations – this is less than meets the eye, because it all still remains contingent.  It is in the eye of the beholder.

No rules, just guesswork from academics and bureaucrats with bad theories on economics.

The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction.  This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.No change.  Changing that would be a cheap way to effect a tightening.
When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.Deleted.
The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.Deleted.
When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.  The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.“Balanced” means they don’t know what they will do, and want flexibility.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Jeffrey M. Lacker; Dennis P. Lockhart; Jerome H. Powell; Daniel K. Tarullo; and John C. Williams.Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Jeffrey M. Lacker; Dennis P. Lockhart; Jerome H. Powell; Daniel K. Tarullo; and John C. Williams.We need some people in the Fed and in the government who realize that balance sheets matter – for households, corporations, governments, and central banks.  Remove anyone who is a neoclassical economist – they missed the last crisis; they will miss the next one.

Comments

  • I will still argue that this was a nothing-burger. The patience language was eliminated, but what were left in its place were contingent conditions that are subject to a wide degree of interpretation.
  • Pretty much a nothing-burger. Few significant changes.  The FOMC has a weaker view of GDP and exports.
  • Despite lower unemployment levels, labor market conditions are still pretty punk. Much of the unemployment rate improvement comes more from discouraged workers, and part-time workers.  Wage growth is weak also.
  • Forward inflation expectations have continued to fall.
  • Equities rise and long bonds rise. Commodity prices rise and the dollar falls.  The FOMC says that any future change to policy is contingent on almost everything.
  • Don’t know they keep an optimistic view of GDP growth, especially amid falling monetary velocity.
  • The FOMC actually chops out “dead wood” from its statement. Brief communication is clear communication.  If a sentence doesn’t change often, remove it.
  • The key variables on Fed Policy are capacity utilization, labor market indicators, inflation trends, and inflation expectations. As a result, the FOMC ain’t moving rates up, absent improvement in labor market indicators, much higher inflation, or a US Dollar crisis.
  • We have a congress of doves for 2015 on the FOMC. Things will be boring as far as dissents go.  We need some people in the Fed and in the government who realize that balance sheets matter – for households, corporations, governments, and central banks.  Remove anyone who is a neoclassical economist – they missed the last crisis; they will miss the next one.

Media Credit: Terence Wright

Media Credit: Terence Wright

This will be a short post. If we get a significant updraft in the price of oil, and Saudi production policy has not changed, you might want to sell crude oil price-sensitive assets. The marginal cost of production for a lot of crude oil that is shale related is around $50/barrel, and that is where I think the market “equilibrium” will bounce around for a few years, until global growth picks up.

I hold my positions for longer periods of time, so I may not do much off of this, but I would expect crude oil prices to be range-bound for a few years, with all of the volatility which a global commodity can have.

That’s all folks.

Photo Credit: Thibaut Chéron Photographies

Photo Credit: Thibaut Chéron Photographies

I wish I could tell you that it was easy for me to stop making macroeconomic forecasts, once I set out to become a value investor.  It’s difficult to get rid of convictions, especially if they are simple ones, such as which way will interest rates go?

In the early-to-mid ’90s, many were convinced that interest rates had no way to go but up.  A few mortgage REITs designed themselves around that idea.  Fortunately, I arrived at the party late, after their investments that implicitly required interest rates to rise soon, fell dramatically in price.  I bought a basket of them for less than book value, excluding the value of taxes that could be sheltered in a reverse merger.

For some time, the stocks continued to fall, though not rapidly.  I became familiar with what it was like to go through coercive rights offerings from cash-hungry companies in trouble.  Bankruptcy was not impossible… and I burned a lot of mental bandwidth on these.  The rights offerings weren’t really good things in themselves, but they led me to buy in at a good time.  Fortunately I had slack capital to deploy.  That may have taught me the wrong lesson on averaging down, as we will see later.  As it was, I ended up making money on these, though less than the market, and with a lot of Sturm und Drang.

That leads me to my main topic of the era: Caldor.  Caldor was a discount retailer that was active in the Northeast, but nationally was a poor third to Walmart and KMart.  It came up with the bright idea of expanding the number of stores it had in the mid-90s without raising capital.  It even turned down an opportunity to float junk bonds.  I remember noting that the leverage seemed high.

What I didn’t recognize that the cost of avoiding issuing equity or longer-term debt was greater reliance on short-term debt from factors — short-term lenders that had a priority claim on inventory.  It would eventually prove to be a fatal error, and one that an asset-liability manager should have known well — never finance a long term asset with short-term debt.  It seems like a cost savings, but it raises the likelihood of insolvency significantly.

Still, it seemed very cheap, and one of my favorite value investors, Michael Price, owned a little less than 10% of the common stock.  So I bought some, and averaged down three times before the bankruptcy, and one time afterwards, until I learned Michael Price was selling his stake, and when he did so, he did it without any thought of what it would do to the stock price.

Now for two counterfactuals: Caldor could have perhaps merged with Bradlee’s, closed their worst stores, refinanced their debt, issued equity, and tried to be a northeast regional retail player.  It didn’t do that.

The investor relations guy could have given a more understanding answer when he was asked whether Caldor was having any difficulties with credit lines from their factors.  Instead, he was rude and dismissive to the questioning analyst.  What was the result?  The factors blinked and pulled their lines, and Caldor went into bankruptcy.

What were my lessons from this episode?

  • Don’t average down more than once, and only do so limitedly, without a significant analysis.  This is where my portfolio rule seven came from.
  • Don’t engage in hero worship, and have initial distrust for single large investors until they prove to be fair to all outside passive minority investors.
  • Avoid overly indebted companies.  Avoid asset liability mismatches.  Portfolio rule three would have helped me here.
  • Analyze whether management has a decent strategy, particularly when they are up against stronger competition.  The broader understanding of portfolio rule six would have steered me clear.
  • Impose a diversification limit.  Even though I concentrate positions and industries in my investing, I still have limits.  That’s another part of rule seven, which limits me from getting too certain.

The result was my largest loss, and I would not lose more on any single investment again until 2008 — I’ll get to that one later.  It was my largest loss as a fraction of my net worth ever — after taxes, it was about 4%.  As a fraction of my liquid net worth at the time, more like 10%.  Ouch.

So, what did I do to memorialize this?  Big losses should always be memorialized.  I taught my (then small) kids to say “Caldor” to me when I talked too much about investing.  They thought it was kind of fun, and I would thank them for it, while grimacing.

But that helped.  Remember, value investing is first about safety, and second about cheapness.  Cheapness rarely makes something safe enough on its own, so analyze balance sheets, strategy, use of cash flow, etc.  This is not to say that I did not make any more errors, but this one reduced the size and frequency.

That said, there will be more “fun” chapters to share in this series, because we always learn more from errors than successes.

Here is the second part of my interview on RT Boom/Bust. It was recorded while the FOMC was releasing its statement, so I had no idea at that time as to what the announcement had been.

The interview covers my view of Apple (not one of my strong points), Fed Policy, and what should value investors do in this low interest rate environment. Note that not all of my opinions are strong ones, and that in my opinion is a good thing. Often the best opinions are not controversial.

If you are interested in these topics, or listening to me, then please enjoy the above video. My segment is about seven minutes long.

Photo Credit: DonkeyHotey

Photo Credit: DonkeyHotey

December 2014January 2015Comments
Information received since the Federal Open Market Committee met in October suggests that economic activity is expanding at a moderate pace.Information received since the Federal Open Market Committee met in December suggests that economic activity has been expanding at a solid pace.Shades GDP up. This is another overestimate by the FOMC.
Labor market conditions improved further, with solid job gains and a lower unemployment rate. On balance, a range of labor market indicators suggests that underutilization of labor resources continues to diminish.Labor market conditions have improved further, with strong job gains and a lower unemployment rate.  On balance, a range of labor market indicators suggests that underutilization of labor resources continues to diminish.Shades their view of labor use up a little.  More people working some amount of time, but many discouraged workers, part-time workers, lower paid positions, etc.
Household spending is rising moderately and business fixed investment is advancing, while the recovery in the housing sector remains slow.Household spending is rising moderately; recent declines in energy prices have boosted household purchasing power.  Business fixed investment is advancing, while the recovery in the housing sector remains slow.Interesting how falls in energy prices are treated as permanent by the FOMC, while rises are regarded as transient.

 

Inflation has continued to run below the Committee’s longer-run objective, partly reflecting declines in energy prices. Market-based measures of inflation compensation have declined somewhat further; survey-based measures of longer-term inflation expectations have remained stable.Inflation has declined further below the Committee’s longer-run objective, largely reflecting declines in energy prices.  Market-based measures of inflation compensation have declined substantially in recent months; survey-based measures of longer-term inflation expectations have remained stable.Shades their forward view of inflation down.  TIPS are showing slightly lower inflation expectations since the last meeting. 5y forward 5y inflation implied from TIPS is near 2.03%, only down 0.04% from December.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.No change. Any time they mention the “statutory mandate,” it is to excuse bad policy.
The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators moving toward levels the Committee judges consistent with its dual mandate.The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators continuing to move toward levels the Committee judges consistent with its dual mandate.No change. They are no longer certain that inflation will rise to the levels that they want.
The Committee sees the risks to the outlook for economic activity and the labor market as nearly balanced. The Committee expects inflation to rise gradually toward 2 percent as the labor market improves further and the transitory effects of lower energy prices and other factors dissipate. The Committee continues to monitor inflation developments closely.The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced.  Inflation is anticipated to decline further in the near term, but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of lower energy prices and other factors dissipate.  The Committee continues to monitor inflation developments closely.CPI is at 0.7% now, yoy.  They shade up their view down on inflation’s amount and persistence.

Okay, so here they regard the energy price declines as transitory.

To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate.  In determining how long to maintain this target range, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation.  This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.No change. Highly accommodative monetary policy is gone – but a super-low Fed funds rate remains.  Policy normalizes, sort of, but no real change.
Based on its current assessment, the Committee judges that it can be patient in beginning to normalize the stance of monetary policy.Based on its current assessment, the Committee judges that it can be patient in beginning to normalize the stance of monetary policy.No change.  In other words, we’re on hold until something goes “Boo!”
The Committee sees this guidance as consistent with its previous statement that it likely will be appropriate to maintain the 0 to 1/4 percent target range for the federal funds rate for a considerable time following the end of its asset purchase program in October, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.Sentence removed, but I doubt that it means much.
However, if incoming information indicates faster progress toward the Committee’s employment and inflation objectives than the Committee now expects, then increases in the target range for the federal funds rate are likely to occur sooner than currently anticipated. Conversely, if progress proves slower than expected, then increases in the target range are likely to occur later than currently anticipated.However, if incoming information indicates faster progress toward the Committee’s employment and inflation objectives than the Committee now expects, then increases in the target range for the federal funds rate are likely to occur sooner than currently anticipated.  Conversely, if progress proves slower than expected, then increases in the target range are likely to occur later than currently anticipated.Tells us what we already knew.
The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction.  This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.No change.  Changing that would be a cheap way to effect a tightening.
When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.No change.
The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.No change.
When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.  The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.“Balanced” means they don’t know what they will do, and want flexibility.  They are not moving anytime soon.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Stanley Fischer; Loretta J. Mester; Jerome H. Powell; and Daniel K. Tarullo.

Voting against the action were Richard W. Fisher, who believed that, while the Committee should be patient in beginning to normalize monetary policy, improvement in the U.S. economic performance since October has moved forward, further than the majority of the Committee envisions, the date when it will likely be appropriate to increase the federal funds rate; Narayana Kocherlakota, who believed that the Committee’s decision, in the context of ongoing low inflation and falling market-based measures of longer-term inflation expectations, created undue downside risk to the credibility of the 2 percent inflation target; and Charles I. Plosser, who believed that the statement should not stress the importance of the passage of time as a key element of its forward guidance and, given the improvement in economic conditions, should not emphasize the consistency of the current forward guidance with previous statements.

Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Jeffrey M. Lacker; Dennis P. Lockhart; Jerome H. Powell; Daniel K. Tarullo; and John C. Williams.A congress of doves for 2015.

Things will be boring as far as dissents go.

We need some people in the Fed and in the government who realize that balance sheets matter – for households, corporations, governments, and central banks.  Remove anyone who is a neoclassical economist – they missed the last crisis; they will miss the next one.

Comments

  • Pretty much a nothing-burger. Few significant changes.  The FOMC has a stronger view of GDP and Labor, and deems the weak global economy to be a reason to wait.
  • Despite lower unemployment levels, labor market conditions are still pretty punk. Much of the unemployment rate improvement comes more from discouraged workers, and part-time workers.  Wage growth is weak also.
  • Forward inflation expectations have flattened out.
  • Has the FOMC seen how low the 30-year T-bond yield is?
  • Equities fall and long bonds rise. Commodity prices are flat.  The FOMC says that any future change to policy is contingent on almost everything.
  • Don’t know they keep an optimistic view of GDP growth, especially amid falling monetary velocity.
  • The FOMC need to chop out more “dead wood” from its statement. Brief communication is clear communication.  If a sentence doesn’t change often, remove it.
  • In the past I have said, “When [holding down longer-term rates on the highest-quality debt] doesn’t work, what will they do? I have to imagine that they are wondering whether QE works at all, given the recent rise and fall in long rates.  The Fed is playing with forces bigger than themselves, and it isn’t dawning on them yet.
  • The key variables on Fed Policy are capacity utilization, labor market indicators, inflation trends, and inflation expectations. As a result, the FOMC ain’t moving rates up, absent improvement in labor market indicators, much higher inflation, or a US Dollar crisis.\
  • We have a congress of doves for 2015 on the FOMC. Things will be boring as far as dissents go.  We need some people in the Fed and in the government who realize that balance sheets matter – for households, corporations, governments, and central banks.  Remove anyone who is a neoclassical economist – they missed the last crisis; they will miss the next one.

Photo Credit: Snowshoe Photography

Photo Credit: Snowshoe Photography

This should be a short post. Weather forecasters deserve to be double-checked, as there has been a tendency among weather broadcasters to sacrifice accuracy for ratings, which can be goosed in the short run by offering a good scare.

I offer the most recent snowstorm as a partial exhibit. There is a real cost to misforecasting, as this article from USA Today points out:

The lost wages and tax revenue from stores and others businesses that shut down early Monday and kept employees home Tuesday, in anticipation of something far more … dramatic.

The vacations, business trips and job interviews disrupted by the pre-emptive cancellation of thousands of airline flights across the Northeast. The extra aggravation caused Monday by those two words that every working parent of school-age children dreads: early dismissal.

All the overkill adds up, in ways that may be impossible to tease out precisely.

Now, many actions are due to a need for caution, but caution needs to be kept in bounds, lest the costs of businesses and government grow without any value gained.  Maybe my bias comes from growing up in Wisconsin, because we were always ready for bad weather, and at least in that era, rarely canceled anything in the winter.

My second observation stems from hurricane forecasting.  Both the overall estimates of the number and severity of storms for the season and the individual estimates of likely severity seem to be biased high.  Again, I blame the need for high ratings.

Yes, we get occasional monster years with hurricanes, like 2004 and 2005.  We also get freak storms like Katrina and Sandy that cause a lot of damage from the degree of flooding that accompanies some severe storms.

As an analyst of insurance companies that insure against many of the losses that come from these storms, it has taken an iron constitution to keep from trading out of loss-exposed insurers when I think the forecast is overly pessimistic.

On a personal level, it is good to be prepared for the kinds of catastrophes common to the area in which you live, regardless of the current predictions.  But where weather affects your business or your investing, I would encourage you to double-check severe weather forecasts to see if they make sense before taking actions as a result.  There are costs to being wrong on each side, so be careful.